What is a Municipal Bond Fund?

A municipal bond fund is a mutual fund that invests primarily in securities issued by municipalities.

How Does a Municipal Bond Fund Work?

Municipal bonds are issued by local or state agencies to raise money for infrastructure projects, such as the construction of a convention center, water treatment facility or regional airport. Generally, these bonds are not subject to federal income taxes.

There are four main categories of municipal bond funds: state, national, insured, and high-yield. In each case, the interest generated by the bonds within the portfolio is typically free from federal income taxes. Additionally, portions of the interest might also be free from state (and local) taxes, as taxpayers are exempt from interest generated by a municipality located within their home state (or city). This makes the first class of municipal bond funds very appealing on a tax-equivalent basis, particularly for investors subject to high state income taxes. For example, residents of California might want to consider a California Municipal Bond Fund.

On the other hand, some investors live in states that do not collect income taxes. In this case, a more diversified national bond fund might be more suitable. These funds are not limited to bonds issued within any one state and are much more flexible.

The third and most conservative category is insured municipal bond funds. This type of fund tends to be the safest of the four, as the securities it invests in are typically backed by an underwriter that has agreed to assume the debt should an issuer default.

Finally, the last category is high-yield municipal bonds, which focus on lower-grade bonds issued by less creditworthy entities. As such, they typically offer the highest yields of all municipal bond funds.

These four main asset classes are then further subdivided according to maturity. Some funds focus on short-term bonds, while others invest in intermediate or long-term securities. As a rule, longer-term funds are more sensitive to changes in interest rates. As such, they tend to be more volatile. However, they also offer higher yields.

Why Does a Municipal Bond Fund Matter?

Municipal bond funds offer broad diversification and professional management. Additionally, they are widely considered to be one of the safest investment classes available, as the principal and interest of the underlying bonds is often backed by a government entity with an ability to impose taxes and/or collect the revenues associated with whatever project the bond proceeds were intended for.

As a tax-advantaged product, municipal bond funds are most appealing to investors in upper tax brackets. However, it should be pointed out that any profits generated by buying and selling within the portfolio are still subject to capital gains taxes. Also, some investors subject to the alternative minimum tax (AMT) may be required to pay taxes on municipal-bond interest.